Wednesday, March 4, 2009

Does taxing high incomes mean taxing the rich?

Politicians (particularly Democrats) and the media talk about high income and wealth as if they were the same thing. In fact, they aren't as correlated as you might think. Many rich people have low incomes (at least low taxable income), and many high earners are not yet rich.

A reasonable definition of rich is that level of wealth where you feel comfortable enough financially to quit your job. You can provide for all of your family's needs, live comfortably, and cover plausible emergencies or catastrophic events, just from the nest egg you have accumulated and the investment returns on that nest egg.

How much do you need to be rich? Most financially savvy people who have thought about the issue think that $3MM is a bare minimum. In today's low interest rate environment, you probably need more, but let's use $3MM as our benchmark.

Obama's tax plan says that households making over $250K are rich. Well, let's take a look at a household that's well into that "rich" bracket -- a 35-year old couple where both husband and wife work and are doing very well. Combined, they make $400K per year. They recently started making that kind of money and up until the present haven't been able to save much. They used to have $150K in retirement savings, which is now down to $100K, and they used to have $100K of equity in their house, but which is now basically nothing.

They have two kids in pre-school, a $400K mortgage, two 5-yr old cars and the usual assortment of modern amenities (groceries from Whole Foods, utilities, cell phones, broadband internet, cable tv, once a week housekeeper, landscaper, once a week babysitter, 2 vacations a year, etc).

I estimate that a fairly tight family budget would total at least $100K/yr outside of mortgage interest and taxes. This includes maintenance and insurance on the house and the cars (plus depreciation on the cars since they need to be replaced every ten years). Their current taxes are as follows:

At the end of the year, they get to save about $136K, and that's by being pretty frugal. So at that rate of saving, this couple won't be rich for over 15 years (this includes investment earnings on their savings), by which time the definition of rich will have moved from $3MM to $5MM.

Don't get me wrong, this family is quite affluent. They are living in a nice house and can easily afford the basic necessities of life. Their spending each year exceeds the total annual income of the vast majority of US households. But these people have very hectic lives, do not feel financially secure, and they are very worried about losing their incomes.

It is also important to recognize that much of the spending that seems extravagant is not really discretionary, but rather necessary to support a two-earner household. Pre-school ($15/yr), babysitters ($3K/yr), housekeeping ($5K/yr), maintaining more than one car ($3K/yr) -- these are items that a one-earner family can do without. So hiking taxes on income but not allowing deductions for these types of expenses definitely penalizes two-income families.

Anyway, my overall point is that income is a poor metric to use to decide who is rich. Income, at least wage income, is a better measure for determining how productive you are, although certainly far from perfect.

I would argue even further that wealth is not the right metric to use to determine who deserves to pay more for the burden of government. If you're rich, but you don't consume, then your wealth doesn't hurt anybody. You are not hogging finite resources for your own enjoyment.

A perfect example is Warren Buffett. He is worth tens of billions of dollars, but the guy probably hasn't spent more than $10MM for himself and his family in his entire lifetime. His vast accumulation of dollars doesn't do me any harm as long as he's not going to use it to consume (i.e. spend it), thereby raising the cost of resources (human, man-made, or natural) for everybody else.

So perhaps the people who deserve to pay the most are those who consume the most. By the way, even poor people can consume quite a great deal. My guess is that the inequality in rates of consumption in the US is far smaller than it is for net worth or income. Consumption should be the true measure of an individual's burden on society and his moral responsibility to pay.